By David D. Tawil
I can't even say that FairPoint Communications is misunderstood. It's not even known.
Originally, FairPoint was a collection of local telephone exchanges spread throughout the U.S. Now it’s the Charlotte, NC-based operator of the un-sexy business of land-line telephone and data services to residential and business customers in 18 states. But the company is a favorite of short sellers. Unfortunately for them, FairPoint’s relative anonymity is going to be great for the bulls and absolutely perilous for the shorts.
Despite an enterprise value of about $1.1 billion, FairPoint’s equity has traded near $7 per share, giving it a total market-capitalization of only $180 million. How did the stock become so depressed? Short-interest in the company’s stock is gigantic. By last count, shorts were 26% of the outstanding float (5.1 million of 19.4 million shares, with 54 days to cover). Shares were shorted at prices as low as $3.50, signaling a belief that FairPoint must be a candidate for a default or bankruptcy. That couldn’t be further from the truth.
Our price target is $25/share. The company is undervalued by a wide margin.
FairPoint is now valued at about four times its past year’s adjusted EBITDA ($260 million), while peers average closer to six times, and FairPoint’s EBITDA is expected to grow. We expect EBITDA to grow to $280 million in 2012 and to $300 million in 2013. In addition, the company’s annual capital expenditures (CapEx) will come down from $176 million in 2011 to $145 million in 2012 and $120 million in 2013.
Ultimately, for most investors in the equity of telecom companies, it’s all about free cash flow and dividends. With EBITDA moving higher and CapEx coming down, free-cash-flow will move from $7 million in 2011 to $50 million in 2012 and $100 million in 2013. With a market capitalization of only $180 million, a 28% free cash flow yield for 2012 and a 55% free cash flow yield for 2013 is extremely valuable.
So why are the shorts so confident? Partially, it has to do with a mucked-up acquisition, which has been remedied by the hard work of new management during the past 18 months.
In 2007, using a lot of leverage, FairPoint purchased Verizon’s telephone network in Maine, New Hampshire and Vermont (its Northern-New England, or NNE, network). Through the NNE acquisition, FairPoint increased its revenue base by six times (in 2007, NNE had revenue $1.1 billion versus the FairPoint’s telecom group revenue of $283 million), and tripled its debt. Through the acquisition, FairPoint became the 7th largest local telephone company in the U.S. (with 1.2 million access lines).
Upon acquisition, FairPoint had difficulty assuming the operational responsibilities (installation, service, billing, etc.). The cutover from Verizon’s systems took much longer than expected and was problematic, leading to an increased cost structure (head-count) and lost market share. This led to a trip through Chapter 11 bankruptcy, which concluded in January 2011 with the reduction of FairPoint’s debt load by 60% and the introduction of a new management team.
Then there’s the issue of the company’s earnings margin, which has historically been lower than that of its competitors as a result of a higher cost structure. Specifically, FairPoint has higher-than-average capital expenditures, which will end this year. And, FairPoint has operated with a higher-than-average workforce, which has started to be right-sized. With these changes, FairPoint’s EBITDA margin should come into line with the industry average, leading to increased cash flow.
For the past few years, FairPoint has spent up to 40% of its annual CapEx on the buildout of its NNE network (this was agreed to with regulators as part of the company’s exit from bankruptcy). That buildout will be completed in 2012 and annual CapEx is expected to fall by $50-60 million (in 2011, CapEx was $176 million; CapEx for the last 12 months is $128 million).
And by industry measures, FairPoint is considerably overstaffed. FairPoint’s peers average about 340 lines per employee; at 3,600 employees, FairPoint’s staffing was 313 lines/employee (FairPoint, December 2011 investor presentation). In 2011, FairPoint reduced its headcount from about 4,000 to about 3,400. Those cuts are expected to save the company $35 million per year, and FairPoint can continue to reduce headcount. The 2011 reduction-in-force focused exclusively on unionized workers among the International Brotherhood of Electrical Workers; the Communications Workers of America workforce can be similarly trimmed, leading to about $70 million of total annual savings.
FairPoint’s management has ambitiously predicted that the second-half of 2012 will be the inflection point for the company’s revenue trend. That is an astounding possibility for a fixed-line communications company, which, like the rest of the ground-losing industry, faces competition from cellular and cable. I know the management team well; they are a very conservative bunch and they wouldn’t set expectations beyond what they think is achievable.
In NNE, FairPoint is the incumbent carrier (the main telephone company in each state). On average, incumbent carriers have greater than 40% market share. FairPoint is well below the average market share. To address that deficiency, FairPoint has made serious changes and progress toward greater penetration. The company’s primary focus is on the business customer. FairPoint has recently hired a chief revenue officer and, in early 2012, reached landmark legislation in all three NNE states that allows the company to compete more successfully with cable providers and competitive local exchange carriers. Moreover, to date, the company has slowed its voice line loss to industry-leading levels and has been gaining steam on its broadband growth.
It’s not just that the shorts don’t know the fundamental story. They also don’t appreciate the precarious technical position they are in.
More than 50% of FairPoint’s equity is concentrated in a half-dozen investors whose shares are not available for borrow. In addition, there are limited additional shares available for borrow; the technical machinations are complete, now the fundamentals will take over.
The short interest has been building over time. More equity was shorted even when the share price was below $4. The only justification for that position is that the company will head into bankruptcy and the shares will be deemed worthless.
Contrary to the thesis necessary to support the short position, since exiting bankruptcy, FairPoint has increased its cash position by 400%, and at the end of its 2nd quarter, the company had total liquidity greater than $100 million. In conclusion, there is no chance that the company will violate its debt covenants. Moreover, as a levered equity ($970 million secured debt at Libor+450 due in 2016), any expansion in the company’s valuation multiple will have a particularly intense effect on the share price.
Moreover, on September 4, 2012, FairPoint made a voluntary payment of $25 million on its secured debt. Management is basically saying they are comfortable with the operations and cash flow generation and that the cash is better utilized to pay down debt.
The company’s path forward is clear. All of the growth is in NNE. By contrast, the telecom group is mature and ripe for divestiture. The company can and should monetize those assets (which have been kept operationally separate from the NNE assets) and use the proceeds to retire debt and delever.
Next, the company will be able to refinance its remaining debt (to allow for equity dividends, among other things) and continue to optimize operations in NNE.
By the end of 2013, FairPoint can achieve $100 million of pro forma net free cash flow. A 50%+ equity dividend is stupendous. Shorts sellers: Watch out.
David D. Tawil is co-founder and portfolio manager for Maglan Capital, a New York hedge fund focused on distressed and event-driven investments.